Friday - February 22, 2008 at 11:07 AM in

Economic outlook

The majority of pundits lately have been thinking
deeply about the economy, at least when they're not obsessed with the scandal du
jour in the presidential contest.

I'm not a pundit, but I occasionally pretend to
be one on the Internet, and I've been thinking about the economy lately. Here's
my conclusions:

First, we are probably
in a recession. When the dust settles, we'll probably decide that the recession
began sometime between November and
January.

Second, I think we're probably
close to the bottom right now (but we won't know that for a good six months or
more). I base this on these
observations:

1) The stock market has
been basically flat for a month now, neither moving significantly up or down.
We may have actually set the bottom in January, though we haven't moved enough
up to be sure that there won't be another bottom in the near
future.

2) The Fed is pumping huge
amounts of liquidity into the economy, and that money is going to have to go
somewhere. Near-term it seems to be going into super-safe investments like
government bonds (and especially inflation-protected bonds), but before long
investors will start looking for more return, and that means investing money in
real businesses and people.

3) Media
reports are uniformly and overwhelmingly focused on the negative, and not the
positive news--and there is positive news out there, it's just hard to find. I
take this as a sign that the mood can't get much worse from
here.

Third, just as in the past couple
economic slowdowns, all the money the Fed is pumping into the economy right now
is likely to lead to a new bubble somewhere in a couple years. Don't believe
me? Look at the pattern: the 1992 recession was arrested by easy money from the
Fed, which contributed to the dot-com bubble. The 2002 recession was also
marked by easy money from the Fed, and that helped pump up the real estate
bubble.

This isn't necessarily a bad
thing. Financial bubbles (despite the problems when they burst) have a number
of desirable side-effects, not the least of which is driving a period of strong
economic growth. Bubbles also tend to create massive investment in
infrastructure which--even if uneconomical when built--lay the groundwork for
future innovations and benefits. For example, a massive amount of fiber-optic
capacity was built in the late 90's, far more than would be needed at the time.
But the telecoms which lost their shirts on that fiber also created the
conditions for cheap bandwidth today and made companies like YouTube
possible.

For the most part, the excess
housing built this decade won't disappear, and (as long as the population
continues to grow) there will be families willing to buy or rent the homes for
the right price.

What's The New
Bubble?If you think there's going to be
a new financial bubble forming in the next few years, it's very useful to know
where the bubble might form. Good candidates are industries or sectors
where:

1) Fundamentals have changed
significantly for the better recently, and are likely to remain favorable. This
could be due to new technology, market conditions, or other
circumstances.

2) Returns have been
good.

3) There's an element of sexiness
or the exotic to pique investors'
interest.

The most obvious place is
alternative energy: if you believe that oil is likely to remain around
$100/barrel or higher for the indefinite future--and this seems a reasonable
assumption--then the fundamentals for renewable energy are strong. Combine that
with improving technology and dropping prices for renewable sources like wind
and solar, and the sexiness of "green energy," and it looks almost
irresistible.

What's more, if you
believe that renewable energy will ultimately have to replace nearly all our
fossil fuel consumption, there's enough demand for renewables to sustain
industry-wide growth of 25% to 50% per year for
decades.

First Draft of a Renewable
Energy PortfolioTo test this investment
thesis, I took a stab at building a model portfolio over the weekend. I started
with a comprehensive list of alternative-energy related companies (which was
hundreds) and applied these
criteria:

1) The stock has to be listed
on the NYSE or NASDAQ. No pink sheet stocks or bulletin board stocks; any
company with serious prospects will have the resources to get listed on a "real"
exchange. Also, no foreign exchanges, since those are harder for Americans to
buy, and I'm not familiar with the foreign accounting and trading
rules.

2) The company has to be
primarily focused on alternative energy. This excludes companies like GE, which
makes a lot of wind turbines, but makes most of its money
elsewhere.

3) No biofuels, because I'm
not convinced that biofuels make economic or environmental sense in the absence
of government supports.

This left me
with 14 companies, all but one of which make solar panels (the other company is
a tiny manufacturer of wave power
systems).

Also, because this is a
hyper-growth industry, I weighted the model portfolio by revenue growth in
dollars from 2006 to 2007. That eliminated two companies which actually shrank
(one due to an accounting change which I didn't want to bother researching). I
also applied a cap of 15% of the portfolio value to individual companies, to
keep it from being too heavily weighted towards a couple big Chinese
companies.

Of the twelve remaining
companies, about 60% of the portfolio wound up in four big Chinese manufacturers
of conventional (polysilicon) solar panels, and First Solar, the upstart thin
film manufacturer, was another
13.5%.

Unfortunately, this has been a
really bad week for my model solar portfolio: all but two of the companies are
down for the week, and the portfolio as a whole is down 15%. Apparently one of
the big Chinese companies lowered its forecasts because of cost and availability
problems with polysilicon, and that pulled down the entire industry (even the
companies not using
polysilicon).

Volatility is to be
expected in this sort of concentrated, speculative portfolio, but I'm really
glad I didn't invest any actual dollars in it this week.